‘Very, very unlikely’ the Fed can rein in inflation without triggering a recession, says former New York Fed chief


Victoria Jones/AFP/Getty Images

Victoria Jones/AFP/Getty Images

By Matt Egan, CNN Business

The Federal Reserve helped save the economy from the worst pandemic in a century. This task may prove easy compared to the Fed’s next mission: to crush inflation, without causing a recession.

Achieving a so-called “soft landing” will be difficult as the job market is on fire. It’s so hot that the unemployment rate may have to rise to bring inflation under control.

“The odds of doing that are very, very low because they have to drive up the unemployment rate,” former New York Federal Reserve Chairman Bill Dudley told CNN.

History is not on the side of the Fed.

“In the past, when you’ve driven the unemployment rate up, you’ve almost never been able to avoid a full-blown recession,” Dudley said. “The problem the Fed is facing is that it’s just late.”

Technically, the Fed has the ability to catch up with inflation by rapidly raising interest rates.

The U.S. central bank is expected to announce its first half-percentage-point interest rate hike since 2000 on Wednesday. Markets are bracing for a series of big rate hikes to quell the worst inflation in 40 years.

In theory, the US central bank can raise interest rates as high as needed to put out the fire of inflation. But the more the Fed does this, the greater the risk of a miscalculation that ends the recovery prematurely.

“That’s why soft landings are so hard to achieve,” said Dudley, who led the New York Fed from 2009 to mid-2018. “By the time you know you’ve done too much, the next thing you know, you’re already in a recession.”

“Very difficult task”

Current Fed officials and some economists express cautious optimism that a feared economic hard landing can be avoided. Fed Chairman Jerome Powell pointed to the soft landings that occurred in 1965, 1984 and 1994.

“I think the historical record gives reason for optimism: soft landings, or at least soft landings, have been relatively common,” Powell said in a speech in March.

However, Dudley notes that in these examples the unemployment rate has not actually increased.

Today, the jobless rate stands at just 3.6%, well within the range the Fed considers full employment. And the unemployment rate is expected to continue to fall, possibly reaching levels not seen since the early 1950s.

“The Federal Reserve needs to slow the economy and generate some slack in the labor market,” Dudley said. “It’s a very difficult mission to carry out.”

The former Fed official said history shows that when the unemployment rate starts to rise, it “usually causes a full-fledged recession.”

It may be for psychological reasons. “People, once they start to see the job market getting worse, they start worrying about their own job prospects. You’re slowing down consumption and spending,” Dudley said.

Low risk of recession for now?

The good news is that a recession does not seem imminent. And Goldman Sachs, Dudley’s former employer, has told clients that a recession is not inevitable.

Dudley said GDP turned negative due to “some crazy stuff” related to stocks and trade, adding that underlying demand in the economy was “strong”.

“There’s very little chance of a recession next year,” Dudley said.

Recession risk above 50% in 2023 and 2024

The concern is how the US economy in 2023 and 2024 will weather a series of interest rate hikes that will drive up the cost of mortgages, auto loans, credit cards and business loans.

Once the Fed brings interest rates back above the neutral level, it will effectively put the brakes on the economy. That’s when the risk of a recession “increases a lot”, Dudley said, adding that the probability of a recession in 2023 and 2024 is “significantly over 50%”.

Of course, the Fed could decide to stop raising interest rates if it fears triggering a downturn.

In some ways, that’s what happened in 2019, when the Powell-led Fed halted rate hikes amid fears of a downturn. Nobody knows how that would have turned out because Covid-19 hit in early 2020, forcing the Fed to cut interest rates dramatically.

“The Fed might try to dither,” Dudley said. “But if they do, inflation will probably come back and then they’ll have to apply the brakes even harder. Procrastination doesn’t really lead to a good result. It just leads to a harder landing on the road.”

Recession fears today – only two years into this economic recovery – underscore the difficult position the Fed finds itself in.

Last spring and summer, the Fed called high inflation “transient,” a term it has since abandoned. The central bank opted to keep its emergency policies in place, hoping inflation would subside.

Inflation has turned out to be more persistent and widespread than economists and investors had expected, in part due to surprises including further supply disruptions from Covid-19 and now the war in Ukraine.

At the same time, the labor market returned to full employment faster than expected. Powell conceded in March that in hindsight, “obviously,” it would have been appropriate had the Fed gone into inflation-fighting mode sooner.

Although Dudley says the Fed deserves “credit” for its “powerful and very rapid” response to the pandemic in early 2020, he suggests it also deserves blame for its response to inflation.

“They were very, very late in removing the monetary policy easing,” Dudley said. “That is going to turn out, in retrospect, to be a bit of a political mistake.”

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